LPs no longer have a level playing field as side letter agreements are increasingly tiered, according to a report from asset management consultancy MJ Hudson.
“What’s happening now is there’s a class-based system forming in private equity – the more money you invest, the better rights you get as an LP,” Eamon Devlin, a partner at MJ Hudson, told Private Equity International.
According to the firm’s Private Equity Fund Terms Research, this can be seen by the application of the most favoured nation treatment, which, “because of the increasing tiering of side letter agreements, can be ‘most favoured’ in name only”. The MFN clause operates to ensure that best terms offered to a preferred investor are offered to all other investors in the fund.
As a result of this tiering, smaller LPs are at a disadvantage and “may ﬁnd themselves shut out from, or not even made aware of, a number of material and signiﬁcant terms because they cannot meet a certain commitment threshold”, the report noted.
Almost 70 percent of funds surveyed offered an MFN clause in their fund terms, an increase from prior years.
Looking at other trends in LP protections, the survey found that the inclusion of a no-fault removal clause is becoming more common. Of the funds in this year’s sample, 63 percent contained a no-fault removal right, an increase from last year when just 53 percent of funds included such a right.
No-fault removal rights appear to be more common in funds managed by GPs based in Europe than in those managed by GPs based in the US. Of all European funds in this year’s sample, 85 percent have no-fault removal rights, while only 22 percent of all US funds have.
“Having the right to remove the manager for any reason is an important right for LPs that’s not been given in most of the US funds that we reviewed,” Devlin said. The right to fire a manager and install a new one is seen as in important right – a practice that is vastly different when it comes to Europe and the US, he added.
“There’s significantly more protection for European LPs in this regard.”
The change of control provisions have also come under closer scrutiny as the sale of minority interests in private equity firms has become more common.
Just over 40 percent of funds surveyed allow the manager to transfer between 25 percent and 50 percent of economic interest in the GP without consent; 26 percent place no restrictions whatsoever on the percentage of economic interest in the GP that principals can transfer; and only 13 percent prohibit any and all such transfers without investor or LPAC approval.
LPs typically want the majority of the economics to go to the team managing the fund, and the change over the last five years of GPs selling parts of their management companies to outsiders has made investors sit up and notice, according to Devlin.
“I think LPs are becoming quite aware of all that; they want to make sure the manager cannot transfer all of the financial economics to another third party.”